Despite mixed local economic data over the summer period, the Reserve Bank of Australia is unlikely to cut interest rates at its first 2013 policy meeting on Tuesday – thanks largely to a rebound in the Chinese economy and strong iron ore prices.
Let's recall that the RBA switched back to rate-cutting mode late last year following the spectacular collapse in spot iron ore prices. With the Chinese economy slowing and surplus iron ore inventories building among Chinese steel producers, iron ore prices dropped from around $US150/tonne in mid-2012 to below $US90 by early September.
But China's economy has since stabilised and iron ore demand returned – which together with disruption to Indian supplies has seen spot prices end last week near last year's highs. Indeed, after decelerating for two years, Chinese economic growth picked up to 7.9 per cent in the year to December, from 7.4 per cent in the year to September, thanks to a modest easing in property restrictions and new infrastructure spending.
A secondary factor supporting steady interest rates is the tentative signs that the reduction in interest rates to date are starting to spark some life into the long-moribund housing sector and business confidence more generally. Home lending continues to grind higher, even in the face of reduced first home buyer demand following the expiration of some state government buying incentives. The value of lending to home owners and investors, excluding refinancing, was 8 per cent higher in November than in February 2012.
Firmer housing demand is also evident in tentative lift in house prices. The RP-Data Rismark National House price index rose 1.2 per cent in January, and almost 2 per cent over the year. National Australia Bank economists note it's the first annual rise in this measure of house prices since April 2011. Looking through the month-to-month volatility, a very gradual uptrend in approvals to build new homes – especially apartments – also appears to have emerged by late last year.
Stability in European financial markets and the ongoing expansion in the US economy – albeit frustratingly modest – are further supportive arguments for leaving interest rates on hold. Spanish and Italian bond yields continue to ease, though they remain uncomfortably high. And despite the small contraction in the US economy during the December quarter, underlying US housing, consumer and business investment demand remain firm. Indeed, I'm still counting on the US economy to surprise on the upside this year, with around 3 per cent growth over the year.
All that said, my base case view remains that the RBA is not finished cutting interest rates. I still expect an official cash rate of 2.5 per cent by mid-year, though possibly a bit later. The reason is that fiscal policy is moving sharply into reverse at a time when large swaths of the non-mining sectors of our economy are still struggling with the high Australian dollar – and which would only zoom higher if the RBA indicated interest rates would remain on hold. Recent surveys suggest business and consumers are still cautious, while subdued hiring intentions indicate the unemployment rate may nudge 6 per cent later this year. While the National Australia Bank business survey reported an encouragingly strong rebound in business confidence during December, the rebound in (less volatile) business conditions was more modest – and both measures remain below their long-run average.
The Westpac/Melbourne Institute measure of consumer sentiment, meanwhile, surprisingly slumped 4 per cent in December with little bounce-back evident in January. Despite very low interest rates and a recent firming in house prices and the sharemarket, consumer confidence is struggling to push much beyond it long-run average level, suggesting consumers won't be dipping into their savings to support the economy any time soon.
Household incomes, meanwhile, could be hit by both slowing wage growth and weakening employment growth. Indeed, the ANZ job advertisements index has fallen for the past 10 months, and together with a below-average reading for hiring intentions from the NAB business survey, suggests a sharp slowing in employment growth is overdue.
Despite the recent rebound in iron ore prices, moreover, it's still likely that the contribution to growth from the mining investment boom will taper off shortly. On that score, we'll get a peak at the investment outlook for 2013-14 when the next official survey of private capital expenditure is released on February 28.
Thankfully, the inflation picture is also somewhat more reassuring following release of the relatively benign December quarter consumer price index report. After rising by a higher than expected 0.75 per cent in the September quarter, underlying inflation was only around 0.5 per cent in the December quarter – leaving annual underlying inflation at 2.25 per cent, or a bit less than the RBA's 2.5 per cent forecast in the November Statement on Monetary Policy.
Low inflation is a necessary but not sufficient condition for lower interest rates in the short term. It gives the RBA more flexibility to cut rates should the economy need more support but, with the global economy and local housing demand tentatively improving, the RBA should find this month is has time on its side.
